Chapter 5 - Postulates, Principles, and Concepts

Accounting Theory: Conceptual Issues
in a Political and Economic Environment

Postulates, Principles, and Concepts
Contributors: By: Harry I. Wolk, James L. Dodd & John J. Rozycki

Book Title: Accounting Theory: Conceptual Issues in a Political and Economic Environment
Chapter Title: "Postulates, Principles, and Concepts"
Pub. Date: 2017
Access Date: September 13, 2018
Publishing Company: SAGE Publications, Inc
City: Thousand Oaks
Print ISBN: 9781483375021
Online ISBN: 9781506300108
DOI: http://dx.doi.org/10.4135/9781506300108.n5
Print pages: 103-133
©2017 SAGE Publications, Inc. All Rights Reserved.
This PDF has been generated from SAGE Knowledge. Please note that the pagination of
the online version will vary from the pagination of the print book.
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Postulates, Principles, and Concepts
Learning Objectives
After reading this chapter, you should be able to:
Understand the significance of Accounting Research Studies Nos. 1 and 3 and why they
failed.
Be familiar with the basic concepts of postulates and principles that underlie historical
costing.
Grasp the equity theories of accounting, their potential usefulness, and their limitations for
analyzing transactions and events.
The need for a theoretical framework in financial accounting has long been felt. The
Committee on Accounting Procedure (CAP) was not concerned with the task of deriving an
underlying framework, but both the Accounting Principles Board (APB) and the Financial
Accounting Standards Board (FASB) have attempted to develop theoretical foundations as a
guide to formulating accounting rules. As briefly mentioned in Chapter 3, the APB attempted
to derive a system of postulates and principles but was unsuccessful. The FASB instituted the
conceptual framework project, a much longer-term endeavor consisting, at the present time,
of seven parts.
Despite the fact that Accounting Research Studies (ARSs) 1 and 3 on postulates and
principles were not accepted, these studies represent a milestone in the attempt to provide a
unified theoretical underpinning for financial accounting rules by the APB. Consequently, it is
important to assess why these studies fell short of the goal of obtaining a framework for APB
accounting opinions. Part of the story has already been told: The project advisers, not to
mention the profession at large, felt the principles were too much in conflict with existing
notions to serve as a frame of reference for the rules that were certain to follow. A closer look
at these early studies helps us understand the FASB ' s conceptual framework and its
prospects.
A discussion of postulates and principles is incomplete without analyzing those concepts that
continue to form an important basis for contemporary historical cost accounting. No matter
what form financial statements may take in the future, it is quite likely that many of these
ideas will be retained, refined, or modified because they have proved useful in an informal but
very pragmatic fashion.
Finally, in this chapter we look at another group of concepts that have long played a role in
interpreting accounting relationships. These are the equity theories of accounting. They are
concerned with the relationship that exists between the firm itself and its ownership interests.
Various inferences can be drawn from these relationships, which can have some influence on
the standard-setting process.
The two appendices to this chapter are the postulates of ARS 1 and the broad principles of
ARS 3. They should be read in conjunction with the discussion of these documents.
Postulates and Principles
Page 2 of 29 SAGE Books - Postulates, Principles, and Concepts

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It cannot be overstressed that the formation of the APB was a watershed in the development
of accounting theory and the role of research. However, Alvin R. Jennings, in his important
speech advocating this new approach to the development of accounting principles, did not
propose the formation of a new rule-making body. What he did envision was a new research
organization within the American Institute of Certified Public Accountants (AICPA) that would
issue statements subject to a two-thirds vote of the Council of the AICPA.1
The Special Committee on Research Program
The result of Jennings ' s ideas was the Special Committee on Research Program, which
stressed the need for articulating the basic set of postulates underlying accounting. In turn,
the principles were to be logically derived from the postulates. The committee thus advocated
a deductive approach. Chapter 2 noted that deductive approaches to theory are basically
normative in outlook. The committee barely mentioned this fact and its implications in its
report:
The general purpose of the Institute . . . should be to advance the written expression
of what constitutes generally accepted accounting principles, for the guidance of its
members. . . . This means something more than a survey of existing practice. It
means continuing efforts to determine appropriate practice and to narrow the areas
of difference and inconsistency in practice. . . . The Institute should take definite
steps to lead in the thinking on unsettled and controversial issues.2
Although the committee foresaw the need for securing the approval of those who would be
subject to the rules of the new APB, it did not anticipate the storm of protest that would erupt
in the wake of ARS 3.3 The committee ' s conception of postulates and principles was also
problematic.
Postulates are generally defined as basic assumptions that cannot be verified. They serve as
a basis for inference and a foundation for a theoretical structure that consists of propositions
deduced from them.4 In systems using formal logical techniques, the basic premises are
called axioms and consist of symbolic notation, and the operations for deducing propositions
are mathematically based.5 The committee ' s report represented postulates in accounting as
few in number and stemming from the economic and political environments as well as from
the customs and underlying viewpoints of the business community. The committee thus
virtually defined postulates and limited their number for the author of ARS 1. One committee
member revealed shortly thereafter that it was not the committee ' s intention to define
postulates.6
The APB committee, on the other hand, did not define broad principles, although it did
compare them in scope to the definitions and pronouncements that had been issued in four
different reports by the American Accounting Association (AAA). These documents and
several supplements were published in 1936, 1941, 1948, and 1957. The first two reports
contain the word principles in their titles, but the word was replaced by standards in the 1948
and 1957 reports (the 1948 revision also used concepts in its title).7 These reports contain
definitions of basic accounting terms, proposed rules for presentation and measurement of
accounting data, and concepts to be applied to published financial reports. The material in
these reports thus covers a wide variety of topics, only some of which might be considered
pertinent to the topic of principles (the basic definitions and concepts, such as disclosure and

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uniformity).
These reports did not use the definition of principles contained in Accounting Terminology
Bulletin No. 1 of the AICPA: “a general law or rule adopted or professed as a guide to action,
a settled ground or basis of conduct or practice.”8 This definition is quite close to the one
used in the philosophy of science, a discipline concerned with scientific method. A principle is
closely related to a law. Both are considered statements of a true and generalized nature
containing referents to the real world as opposed to purely analytic statements whose truth or
falsity is self-contained by their internal logic.9
A law contains elements observable by empirical techniques, whereas a principle does not. If
a principle can be empirically tested and proven true (or at least not proven false), it is
capable of becoming a law.10 Principles are general statements that influence the way we
view phenomena and the way we think about problems.11 The “truth” of a law or principle
does not mean that it is incapable of replacement by newer systems. However, changes '
particularly in the case of laws ' should be extremely infrequent.
Accounting Research Study No. 1 (ARS 1)
Given his charge by the Special Committee, Moonitz adopted a frame of reference or outlook
that was oriented to the problems dealt with by accountants. He rejected a deductive
approach rooted in reasoning alone because it was not broad enough to encompass the
experiential and empirical aspects of accounting. Deinzer correctly pointed out, however, that
Moonitz did eventually revert to the axiomatic (meaning deductive) method.12 He did indeed
use a deductive type of approach ' but without employing symbolic terminology and formal
methods ' in terms of reasoning to a second level of postulates and some of the principles.
However, the postulates themselves are of two decidedly different types. One category (the A
and B groups) is made up of general, descriptive postulates that appear to coincide with the
committee ' s charge that postulates should be derived from the economic and political
environments and modes of thought and customs from all segments of the community. The
second category (the C group) is value judgments. It is this group that may have gone against
the committee ' s charge and definitely labels Moonitz ' s work as deductive – normative in
scope.
The postulates themselves (see Appendix 5-A) are in three groups: the environmental group
(A), those stemming from accounting itself (B), and the imperatives (C). Some postulates in
the B group appear to stem from the A category, which led to the criticism that no postulates
should be reasoned from any others and a similar criticism that postulates were given a rank
order. Although these criticisms may have some validity, they could easily be overcome by
relabeling. There is no rule that only two levels (postulates and principles) can be used in
deductive reasoning. A complex environment, such as that in which accounting operates, can
have numerous levels.
A far more telling criticism was that self-evident postulates may not be sufficiently substantive
to lead to a unique and meaningful set of accounting principles. This unquestionably appears
to be the case with both the A and B groups. If postulates are indeed defined as self-evident
generalizations from a particular environment, this raises the question of what their role is in a
deductively oriented system in which principles form the basis for more specific rules. Of
necessity, it appears that postulates must play a more passive role. The principles and rules

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should not be in conflict with them, but alone they are not sufficiently important to lead to the
desired principles and rules.13 They are thus necessary, but not sufficient to lead to a viable
outcome.
Hence, the key group in Moonitz ' s set of postulates is the imperatives. These appear to be
more akin to what Mautz has called “concepts” because (a) they are normative in nature and
(b) they have developed within the context of accounting practice.14 The imperatives have the
flavor of being objectives that should be attained, which is also a result of their normative
aspect.
The key postulate appears to be C-4, stability of the monetary unit. This postulate appears to
have two possible outcomes. If purchasing power of the monetary unit is not stable, the
postulate implies that some form of inflation accounting should be instituted. If, on the other
hand, purchasing power of the monetary unit is relatively stable, two further consequences of
the postulate arise ' one is that retention of historical cost is justified; the other is that a
system of current values is still warranted, despite general stability of the monetary unit,
because demand changes can cause considerable price fluctuation for individual products
and services. The dual interpretation of C-4 is a definite weakness of this very important
postulate. Perhaps Postulate A-1, usefulness of quantitative data, should lead to current
values, but this is certainly not self-evident from the Moonitz postulates. At any rate, the
profession was generally silent when the postulates appeared. It was undoubtedly awaiting
the appearance of the broad principles study.
Accounting Research Study No. 3 (ARS 3)
There are eight broad principles in ARS 3 (see Appendix 5-B). At least three of them (A, B,
and D) deal with the problems of changing prices, which was the point of departure for the
profession ' s rather stinging rejection of the study. It is interesting to note that the summary of
the eight principles covers some four and one-half pages, two and one-half of which are
devoted to Principle D, the asset valuation principle.
Deinzer very appropriately noted that Principle A ' which states that revenue is earned by the
entire process of operations of the firm rather than at one point only, usually when sale occurs
' was not reasoned from any of the 14 postulates.15 It would appear, then, to belong in the B
group of postulates. More importantly, Sprouse and Moonitz apparently needed it to pave the
way for their value-oriented principles because it underlies the recognition of changes in
replacement cost, which leads to holding gains or losses (Principle B-2).
One of the most pointed criticisms of the asset valuation measures prescribed in Principle D
was that they are not additive. That is, although current value dollars are being used, different
attributes or characteristics are being measured; hence, they cannot theoretically be
combined by addition because Sprouse and Moonitz advocated different current-value
characteristics for different asset classes. For example, if inventory can easily be sold at a
given market price, net realizable value (selling price less known costs of disposal) should be
used (D-2). On the other hand, the value of fixed assets, which are not intended for sale, is
rooted in terms of the service they can provide over present and future periods. As a result,
Sprouse and Moonitz opted for replacement cost as the appropriate characteristic of
measurement for this class of assets (D-3). Obviously, the additivity question, where different
attributes are being measured, has strong overtones of measurement theory.

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Chambers was the principal critic of the lack of additivity of asset values put forth by the broad
principles of ARS 3.16 Chambers strongly advocated the exit-value approach illustrated in
Chapter 1, although his position is blurred by his acceptance of replacement cost as a
secondary valuation if exit values were unavailable.17 However, it should be clear that
Chambers was attempting to separate conceptual or theoretical issues from measurement
problems. Hence, it would almost appear that the additivity issue can be breached only if one
' s heart is in the right place. The basic theoretical system should be unified in terms of one
primary characteristic of assets and liabilities to be measured. However, a less desirable
measurement must be employed where the primary measurement system falls short of being
able to provide the needed numbers. Nevertheless, the primacy of conceptual issues over
measurement problems cannot be ignored. The answer probably lies in determining which
current value elements have the most utility for financial statement users, an issue not
addressed by Sprouse and Moonitz.
A last criticism to be leveled at ARS 1 and ARS 3 was that a set of postulates should be
complete enough to allow no conflicting conclusions to be derived from them. Postulate C-4
says that the monetary unit should be stable. From it, Principle D was derived advocating
various current values for different categories of assets. The various choices espoused in
Principle D cannot be justified to the exclusion of other possibilities. Hence, the postulate
system is not theoretically tight enough to justify it, whether or not one agrees with the
resulting principles.
A Perspective on ARS 1 and ARS 3
ARS 1 and ARS 3 failed for a variety of reasons in addition to the most obvious one ' the
profession ' s inability to abandon historical costs. The postulates and principles themselves
had several weaknesses. The postulates were not complete and, therefore, could not exclude
other value systems than the one prescribed in the principles. Additionally, at least one
principle, Principle A, was not derived from any of the postulates. Finally, the question of
whether resulting valuations of various assets should be additive (because they advocated
different attributes) became an interesting, and probably moot, point.
Even beyond the questions of logic and adequacy of ARS 1 and ARS 3, a number of issues
have since made it clear that the Moonitz – Sprouse efforts could not succeed. It appears that
Moonitz and Sprouse were commissioned to find those postulates and principles that would
lead to “true income” ' in other words, to use a single concept of income that would show it
superior to all other challengers. In retrospect, it is evident that no income measurement can
be deemed to have such an advantage over competing concepts.
Aside from Postulate A-1, which states that “quantitative data are helpful in making rational
economic decisions,” virtually nothing is said in either study about who are the outside users
of accounting data and what their particular information needs and abilities might be. It is
generally conceded today that users of financial data (with their underlying information needs
and abilities to understand and manipulate financial data) cover a broad, relatively
heterogeneous spectrum. However, the emphasis on users was not a particularly prominent
theoretical accounting issue when ARS 1 and ARS 3 were published. Thus, the postulates
and principles approach tended to overlook a theoretical area that has since received a great
deal of attention. The rise of the user-needs outlook produced a new focus on the objectives
of published financial statement data. Indeed, as we mentioned, several of the imperative
postulates actually began to spill over into the area of financial statement objectives.

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Formulating the objectives of financial statements and reporting has become an extremely
important part of theory formulation.
Finally, we note that the commissioning of ARS 1 and ARS 3 occurred at a time when little
formal attention was given to what might be called the politics of rule making. By this we
mean that under the FASB there is more opportunity to react to potential accounting rules for
those who will be subject to them than was the case with the APB.
Some might say that the postulates and principles studies were a dismal failure. As we view
events from the perspective of many decades, we realize that this is not the case. These
studies should hold an important place in the history of accounting theory for no other reason
than the fact that they were the first attempt in the United States by the practicing arm of the
profession to provide a conceptual underpinning for the rule-making function. Furthermore, by
examining the difficulties encountered by the APB in drafting a theoretical statement that
would meet the approval of those who would be governed by it, the FASB should have
learned valuable lessons for its conceptual framework project.
Basic Concepts Underlying Historical Costing
Many accounting concepts have long influenced accounting rules. These concepts largely
evolved from practical operating necessities, including income tax laws, but also appeared in
several theoretical works written mostly in the formative years (1930 – 1946) of accounting
policy-making groups.18 Perhaps the most outstanding of these was the monograph by
Paton and Littleton, An Introduction to Corporate Accounting Standards, which approached
theory deductively rather than from the point of view of what was being done in practice.19
This work was not revolutionary, but it did attempt to provide a basic framework that the
enterprise could use to assess its accounting practices. The authors hoped that a greater
degree of consistency in accounting practice resulted from their effort.
Other important works of this period included the following:
Canning ' s attempt to relate asset valuation to future cash flows

Separate books by Sweeney and MacNeal, which, respectively, were concerned with
accounting for the changing value of the monetary unit and the weakness of historical
costs
Sanders, Hatfield, and Moore ' s monograph on deriving the principles of accounting from
practice
Gilman ' s book about refining the concept of income
Littleton ' s attempt to derive inductively the accounting principles underlying relevant
practice20
The concepts discussed in this chapter have been called postulates, axioms, assumptions,
doctrines, conventions, constraints, principles, and standards. The word concepts is probably
an accurate overall label for these terms. A concept is the result of the process of identifying,
classifying, and interpreting various phenomena or precepts.21 It is thus not part of the formal
process of theory formulation, but can be used within a theory ' as part of the structure of
postulates, or in the conclusions deduced from thepostulates, or even as the subject of
testing in empirical research. Many elements fall into the concept category in accounting, and
they are quite rightly considered part of accounting theory. Many have been and will be part of
a general theoretical framework for interpreting and presenting financial accounting data as

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well as individual accounting theories. Indeed, several concepts are discussed in Chapter 7 in
terms of their place in the conceptual framework of the FASB.
Attempts (such as those mentioned in Chapter 2, ARS 1 and ARS 3) to set up deductive
systems of postulates and principles failed to achieve a high degree of consensus owing to
lack of rigor in reasoning, overlapping definitions, and different value judgments.22 Bearing
this in mind, we have given the following organization to our discussion of concepts strictly for
teaching purposes. The concepts are broken down as follows:
Postulates are basic assumptions concerning the business environment.

Principles are general approaches utilized in the recognition and measurement of
accounting events. Principles are, in turn, divided into two main types:
1. Input-oriented principles are broad rules that guide the accounting function. Input-
oriented principles can be divided into two general classifications: general underlying
rules of operation and constraining principles. As their names imply, the former are
general in nature whereas the latter are geared to certain specific types of situations.
2. Output-oriented principles involve certain qualities or characteristics that financial
statements should possess if the input-oriented principles are appropriately executed.
A schema of these various concepts is shown in Exhibit 5.1.
Postulates
Going Concern or Continuity
The going-concern postulate simply states that unless there is evidence to the contrary, it is
assumed that the firm will continue indefinitely. As a result, under ordinary circumstances,
reporting liquidation values for assets and equities is in violation of the postulate. However,
the continuity assumption is simply too broad to lead to any kind of a choice among valuation
systems, including historical cost. Fremgen and Sterling criticized this postulate extensively.23
Sterling logically demolishes it because the time period of continuity is presumed to be long
enough to conclude the firm ' s present contractual arrangements. However, by the time these
affairs are concluded, they will have been replaced by new arrangements. Hence, the
implication is one of indefinite life. On the other hand, we know that over the long run, many
firms do conclude their activities. Therefore, continuity is more in the nature of a prediction
than an underlying assumption. Suffice it to say that, aside from ordinarily excluding
liquidation values, going concern has little to add to accounting theory.
Exhibit 5.1 Basic Concepts Underlying Historical Costing

Postulates Principles
Going Concern
Time Period
Accounting Entity
Monetary Unit

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Input-Oriented Principles
General Underlying Rules of Operation

1. Recognition
2. Matching
Constraining Principles
1. Conservatism
2. Disclosure
3. Materiality
4. Objectivity (also called verifiability)
Output-Oriented Principles
Applicable to Users
1. Comparability
Applicable to Preparers
1. Consistency
2. Uniformity
Time Period
Business, as well as virtually every form of human and animal activity, operates within fairly
rigidly specified periods of time. The time period idea is, nevertheless, somewhat artificial
because it creates definite segments out of what is a continuing process. For business
entities, the time period is the calendar or business year. As a result, of course, financial
reports contain statements of financial condition, earnings, and funds flow over a year ' s time
or a portion thereof. Since the year is a relatively short time in the life of most enterprises, the
time period postulate has led to accrual accounting and to the principles of recognition and
matching under historical costing. Furthermore, even though the needs of users required
financial reporting for less than full-year intervals, these interim financial statements have their
own problems and sets of rules. APB Opinion No. 28 states in general, however, that
accounting methods followed in annual financial statements must likewise be followed in
interim reports. Hence, interim reports must include estimates of annual amounts.
Accounting Entity
When we view the business entity in the context of accounting as well as in its legal form, it is
clear that the entity is separate from its owners, but there are nevertheless two important
problems.
First is the problem of defining the entity and accounting for the relationship among its parts.
Involved here is the question of whether entities should be considered as one unit as a result
of one controlling the other(s). In other words, should accounts be combined or should a
noncombinative method of showing the relationship be used? The whole combination issue is
made more complex by the presence of foreign operations.
The second issue related to the question of the accounting entity concerns the relationship
between the firm and its owners. While the accounting is separate, the point of interface
between the firm and the owners exists in the owners ' equity accounts. A number of
deductive theories purport to describe this relationship and the role of the owners ' equity

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accounts. These ideas influence our interpretation of what constitutes income, the meaning of
equities, and other important issues. The equity theories, as they are called, are discussed
later in this chapter.
Monetary Unit
In nonbarter economies, money serves as the medium of exchange. As a result, money has
also become the principal standard of value and is subject to the measurement process.
Thus, financial statements are expressed in terms of the monetary unit of their particular
nation or by means of a common monetary unit such as the Euro in the European Union. The
assumption, for accounting purposes, that the monetary unit is stable became a mainstay of
accounting principles and methods. Hence, the historical cost principle became enshrined as
a virtually unchallengeable tenet of accounting.
Severe inflation in the 1970s in the United States and other nations encouraged a fresh
examination of valuation theories and new ways of presenting financial information. Current
valuation arises in areas such as marketable securities (SFAS No. 115), impaired assets
(SFAS No. 121), and derivatives (SFAS No. 133), and SFAS No. 157 instituted a fair (current)
value measurement system.
Principles
The word principles is not well defined in ARSs of the AICPA. Neither ARS 1 nor ARS 3
precisely defines the word, although the latter contains the phrase “broad accounting
principles” in its title. Paul Grady indicated in the preface of ARS 7 that he regarded
accounting principles as synonymous with practices.24 However, some 400 pages later,
Grady identifies principles as postulates derived from “experiences and reason” that have
proved useful.25 Deductively, then, it appears that principles are postulates that have been
successful in practice, an interpretation that Grady himself would probably tend to reject.
Perhaps the most useful definition of principles in official publications comes from APB
Statement 4. Generally accepted accounting principles, it says, are rooted in “experience,
reason, custom, usage, and . . . practical necessity.”26 Furthermore, they “encompass the
conventions, rules, and procedures necessary to define accepted accounting practice at a
particular time.”27 This still overlaps with Grady ' s definition, in which principles are identified
with acceptable practice, but it distinguishes principles from postulates even though they
stem from practical necessity and related experiences.28 However, a subset of generally
accepted accounting principles, pervasive principles, is largely synonymous with the way the
term is used in APB Statement 4:
Pervasive principles [italics added] are few in number and fundamental in nature . . .
pervasive principles specify the general approach accountants take to recognition
and measurement of events that affect the financial position and results of
operations of enterprises.29
Notice that both definitions of principles from APB Statement 4 do not include the idea of
permanence that is given to the word in the scientific sense. Pervasive principles in
accounting overlap with what we refer to here as input-oriented principles.

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Input-Oriented Principles
Accounting principles are classified here into two broad types: input-oriented principles and
output-oriented principles. The distinctions between these groups are at least somewhat
clear. Input-oriented principles are concerned with general approaches or rules for preparing
financial statements and their content, including any necessary supplementary disclosures.
Output-oriented principles are concerned with the comparability of financial statements of
different firms. Although some of these principles apply to preparers of the statements and
others to users, there is a close linkage between them.
General Underlying Rules of Operation
The first group of input-oriented principles is the general underlying rules of operation. These
are further broken down into those involved with revenue recognition and those involved with
expense recognition. These principles illustrate the primary orientation of historical cost
accounting toward income measurement rather than asset and liability valuation.
Recognition.
Revenue is defined here as the output of the enterprise in terms of its product(s) which may
be either goods or service(s). Notice that this definition says nothing about the receipt or
inflow of assets as a result of revenue performance because defining revenue in this way can
easily lead to problems in terms of when to recognize revenue as being earned. It is generally
conceded that revenues arise in conjunction with all of the operations of a firm.30 For a
manufacturing enterprise, these operations include acquisition of raw materials, production,
sale, collection of cash or other consideration from customers, and after-sale services such as
product warranties and guarantees.
Recognition concerns the problem of when to enter revenues and expenses in the accounts.
The most prevalent revenue recognition point by far is at the point of sale. Other possibilities
may, however, arise; for example, revenue may be recognized in accordance with the firm ' s
critical event. The critical event is the operating function that is the most crucial in terms of the
earning process.31 Revenue recognition points are discussed in Chapter 12. Suffice it to say
that the revenue recognition principle is the most pervasive in the canon of historical cost
accounting.
The conceptual framework project of the FASB states that revenue recognition occurs in
accordance with two criteria: (1) The assets to be received from the performance of the
revenue function are realized or realizable, and (2) performance of the revenue function is
“substantially accomplished.”32 In the latter case, revenues are referred to as being earned, a
commonly used term for revenue performance. This conception of revenue recognition has its
roots in that fountainhead of the historical cost approach, the Paton and Littleton monograph
previously mentioned.33 The terms realized and realizable refer to the conversion or ready
convertibility of the enterprise ' s product or service into cash or claims to cash. Realized
means that the firm ' s product or service has been converted to cash or claims to cash, while
realizable has been defined as the ability to convert assets already received or held into
known amounts of cash or claims to cash.34 Realization is often used as a synonym for
recognition.35 The conceptual framework project appears to have been instrumental in having
the word recognition supplant realization. Attempts to breach revenue recognition rules by

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recognizing revenue early in order to inflate current income are a considerable problem today.
More is said about this issue in Chapter 12.
Matching.
Expenses are defined as costs that expire as a result of generating revenues. Expenses are
thus necessary to the production of revenues. If all expenses were directly identified with
either specific revenues or specific time periods, expense measurement would present few
problems. Unfortunately, many important expenses cannot be specifically identified with
particular revenues, and they also bring benefit to more than one time period.
The process of recognizing cost expiration (expense incurrence) for categories such as
depreciation, cost of goods sold, interest, and deferred charges is called matching. Matching
implies that expenses are being recognized on a fair and equitable basis relative to the
recognition of revenues. Matching is thus the second aspect, after recognition, of the primacy
of income measurement over asset and liability valuation in our present system, which is
oriented toward historical cost.
Currently, matching is under extensive attack. First, the historical cost approach often tends to
substantially understate expense measurements relative to the value of expired-asset
services. Second, the “systematic and rational” methods employed under generally accepted
accounting principles tend to be extremely arbitrary: A particular problem can be handled in
more than one way. This imprecision is known as the “allocation problem” and is discussed in
Chapter 9.
Constraining Principles
The second group of input-oriented principles ' constraining principles ' partially overlaps with
the “modifying conventions” mentioned in APB Statement 4. These principles are described in
the following fashion: “Certain widely adopted conventions modify the application of the
pervasive measurement principles. These modifying conventions . . . have evolved to deal with
some of the most difficult and controversial problem areas in financial accounting.”36 The
constraining principles either impose limitations on financial statements, as in the case of
conservatism, or provide checks on them, as in the case of materiality and disclosure.
Conservatism.
Unquestionably, conservatism holds an extremely important place in the ethos of accountants.

Indeed, it even is called the dominant principle of accounting.37Conservatism, f r o m a
preparer ' s if not a standard setter ' s orientation, is defined here as the attempt to select
“generally accepted” accounting methods that result in any of the following: (a) slower
revenue recognition, (b) faster expense recognition, (c) lower asset valuation, (d) higher
liability valuation. However, in certain situations some of these criteria can conflict. If so, lower
income considerations take precedence over higher asset valuations in determining whether a
method or approach is conservative. For example, in the case of current valuation of assets,
one approach ' called distributable income ' does not include real holding gains in the
computation of income. As a result, in an inflationary environment, distributable income often
results in higher asset valuations and lower income calculations than would occur under the
historical cost alternative. Therefore, the distributable-income approach to current valuation
can be more conservative than historical costing even though, generally speaking, historical

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cost is assumed to be more conservative.
Basu, in a capital markets – oriented context, has interpreted conservatism to mean that “bad
news” (the loss of a major customer, for example) relative to reported earnings has a greater
impact on security prices than “good news.” Basu has found statistical evidence supporting
this point.38
Bushman and Piotroski are in agreement with Basu that the more “bad news” beats out “good
news” in terms of swiftness of reporting, the more conservative the institutional setting.39
Bushman and Piotroski ' s particular contribution lies in their observation that the more fully
developed the financial and legal institutions (e.g., courts, Securities and Exchange
Commission, Federal Trade Commission) are, the more conservative the accounting rules
(e.g., recognizing loss contingencies prior to gain contingencies).40
Givoly and Hayn found evidence of conservative financial reporting over time for 896 firms
from 1968 to 1998.41 Various indirect measures were used, such as the ratio of market value
to book value growing over time (indicating a conservative balance sheet) and growth in the
ratio of income from continuing operations to total assets. The Givoly and Hayn study should
help to put into better perspective some of the recent startling headlines about corporate
financial reporting behavior, although earnings management (Chapter 12) remains an
extremely important problem.
Watts also sees conservatism as a dominating element of financial accounting.42 He notes

that it stems from both management and standard setters. On the management side, he sees
conservatism stemming from contracting arrangements such as debt covenants covering
bond issues, attempts to avoid litigation by understating assets, and minimization of taxes.43
However, relative to standard-setting agencies, he sees the tide going from a conservative
orientation (recognizing probable loss contingencies, but not gain contingencies in SFAS No.
5, for example) to more of a future-oriented outlook, helping users predict cash flows (see
conceptual framework, Chapter 7). Along the same line, the FASB has backed off an overly
dominating place for conservatism since it is not listed in the hierarchical qualities of the
conceptual framework, although it is still seen as a “prudent reaction to uncertainty.”44
As mentioned above, earnings management ' which usually arises in regard to management
attempting either to meet earnings forecasts or to maximize management compensation
arrangements ' puts an upward spin on calculating earnings numbers. Watts believes that
conservatism is a more important factor than earnings management. We tend to agree with
him because we believe that earnings management arises in a more ad hoc short-term
context whereas conservatism generally has a longer-run impact, but the relationship
between them is certainly open to further examination and research.
Disclosure.
Moonitz construed disclosure as an imperative postulate (C-5). However, he described it in

negative terms: “that which is necessary to make them [accounting reports] not misleading.”
The fact that it is difficult to quantify the concept of adequate disclosure for users may be the
reason for Moonitz ' s phrasing and for the failure of the Securities and Exchange Commission
(SEC) or AICPA sources to define the concept adequately.45 The FASB has not defined it,
although two important FASB Statements, in particular, dealt with it: SFAS No. 131 on

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segmental disclosures and SFAS No. 33 on general price-level and current value data. SFAS
No. 131 requires segmental disclosures by management ' s own choice for making operating
decisions and assessing performance. One issue that is arising relative to disclosure concerns
its credibility or believability, which is becoming more important in the light of recent major
accounting scandals. Mirroring the conservatism dichotomy mentioned previously that “bad
news” affects security prices more than “good news,” researchers found that negative news
disclosures are more credible than positive news disclosures.46
Disclosure refers to the presentation of relevant financial information both inside and outside
the main body of the financial statements themselves, including methods employed in
financial statements where more than one choice exists or an unusual or innovative selection
of methods arises.47 The principal outside categories include the following:
Supplementary financial statement schedules, such as those pertaining to SFAS No. 131
and SFAS No. 33 (superseded by SFAS No. 89)
Disclosure in footnotes of information that cannot be adequately presented in the body of
the financial statements themselves
Disclosure of material or major poststatement events in the annual report
Forecasts of operations for the forthcoming year
Management ' s analysis of operations in the annual report
Lang and Lundholm found that disclosure activity frequently increases approximately six
months prior to a stock offering.48 This often results in a stock price increase and a lower cost
of capital. If the stock price increase is maintained, it could indicate a lessening of information
asymmetry, but if it is not maintained, it may indicate that the stock has been “hyped”: The
information may be misleading or positive conditions may have been overemphasized.
There are two important reasons for believing that disclosure becomes even more important in
the future. First, as the business environment grows more complex, expressing important
financial and operating information adequately within the confines of the traditional financial
statements becomes more difficult. Second, a considerable body of evidence indicates that
capital markets are able to absorb and quickly reflect new information within security prices.
However, wherever possible, information is preferable within the body of financial statements
themselves rather than appearing only in footnote disclosures.
Materiality.
Materiality refers to the importance of an item (or group of items) to users in terms of its
relevance to evaluation or decision making. We can thus view it as the other side of the
disclosure coin because what is disclosed should, of course, be material. Unfortunately,
materiality levels are determined by auditors on a case-by-case basis and can vary greatly
among auditors, among companies, and even by the same auditor over time.49 Moreover,
external users are not informed of the materiality level used by the auditor.
An early and extensive attempt to assess quantitative perceptions of materiality was

conducted in Pattillo ' s study for the Financial Executives Research Foundation (FERF).50
Pattillo used 684 respondents, including preparers of financial statements (financial
executives from Fortune 500 and medium-sized firms), users of accounting information
(bankers and financial analysts), auditors, and also academics, to use their own materiality
judgments on 28 cases. Pattillo ' s major findings included the following:

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Although many respondents usually use a range of 5% to 10% of net income as the
boundary of materiality, they did not apply a single absolute dollar or percentage
relationship to all situations.
Perceptions of materiality differ between groups, with financial executives having the
highest percentage threshold of net income and certified public accountants and financial
analysts having the lowest overall percentage.
Modifying elements, such as the particular characteristics of the firm and the political and
economic environment, influence the perception of materiality in particular situations.
In a study using a computer simulation, Turner found that immaterial errors can combine,
resulting in a significant impact on financial ratios.51 This error effect is more pronounced on
profitability ratios such as profit margin on sales and return on assets than on solvency ratios
such as the current ratio and debt-to-equity ratio. Among other recent materiality studies is an
attempt to measure it from the user perspective, concentrating on the vantage points of (a)
percentage effect on net income, (b) percentage effect on revenues, and (c) percentage effect
on total assets.52 Using “unexpected earnings” divided by the three factors mentioned above
Cho et al. (2003) found that the average investor ' s materiality threshold is in the range of
0.1% to 0.2% of pretax income, a range significantly below the range of 5% to 10% of net
income found by Pattillo and the range used in the auditing literature. These and other
empirical studies helped to shed light on the concept of materiality, although it is not a settled
issue.53
Despite difficulties, attempts are being made to tighten materiality boundaries. The SEC in
Staff Accounting Bulletin (SAB) No. 99 tried to provide materiality guidance for auditors,
although it did not provide precise percentage standards of materiality.54
Sarbanes-Oxley (SOX) is also involved with materiality. In discussing SOX, Vorhies notes that
using a benchmark of a 5% materiality level as a percentage of income, pretax net income is
“normalized” by adjusting net income from continuing operations (for unusual events not
expected to recur) to arrive at the basic materiality threshold.55 However, errors and
misstatements may still be material even if they fall below 5%. Errors should be aggregated,
even though individually small, to see if they breach the 5% barrier.56 Also, any internal
control deficiencies must be evaluated with the 5% materiality threshold in mind. If the
accounting estimation process is flawed, the materiality threshold must also be kept in mind.
Finally, materiality must also be considered if fraud arises in a context where the firm ' s
financial statements have been misstated.57
It is clear that materiality, along with disclosure, continues to be an important issue in the
foreseeable future, not only in the United States, but in other countries as well.58
Objectivity.
In the past, objectivity has been interpreted in several different ways, but primarily in terms of
the quality of evidence underlying transactions that are eventually summarized and organized
in the form of financial statements.59 The concept of quality of evidence was considered apart
from the measurement function. Now, however, objectivity is more commonly thought of in the
statistical sense (discussed in Chapter 1) as the degree of consensus among measurers. It is,

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therefore, an integral part of the measurement process rather than being either a postulate or
principle. APB Statement 4 adopts this outlook, although it discusses the concept as a
“qualitative objective” of accounting and relabels it as verifiability.60 This newer, statistical
sense of verifiability also appears in the Statement of Financial Accounting Concepts No. 2 of
the conceptual framework project of the FASB.
Output-Oriented Principles
As mentioned earlier, output-oriented principles express qualities that financial statements

should possess when viewed from the standpoint of both preparers and users. Of necessity,
then, these concepts both somewhat overlap and complement each other. As viewed here,
comparability is a concept that applies to users of financial statements, whereas consistency
and uniformity focus on preparers of financial information.
Comparability
Comparability has often been described as accounting for like events in a similar manner, but
this definition is too simplistic to be operational.61 The term also applies to those users of
financial statements. Comparability, viewed here from the user ' s standpoint, refers to the
degree of reliability users should find in financial statements when evaluating financial
condition or the results of operations on an interfirm basis or predicting income or cash
flows.62
Obviously, then, comparability is largely dependent on the amount of uniformity attained in

recording transactions and preparing financial statements. Despite the secondary role of
comparability relative to uniformity, the cost – benefit relationship between them should be
kept in mind: Comparability might be improved by more uniformity, but costs may exceed
benefits.
Consistency
Consistency refers to a given firm ' s use of the same accounting methods over consecutive
time periods. Consistency is necessary if over more than one time period, predictions or
evaluations based on a firm ' s financial statements are to be reliable. Should change occur '
because of adoption of a more relevant or objective method ' full disclosure must be made to
users and the auditor ' s opinion is appropriately qualified.
Consistency is really an aspect of the broader issue of uniformity. Some believe that differing
circumstances among firms, particularly when different industries are involved, make it
impossible to attain uniformity of accounting techniques on an interfirm basis.63 Therefore,
consistency on an intrafirm basis, with full disclosure when changes occur, is the most
practical goal relative to output-oriented principles.
Uniformity
Uniformity has been and continues to be an important issue in accounting. But it has several
subtle aspects that are not always fully taken into account. Interpretations of uniformity
include the following:

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A uniform set of principles for all firms, with interpretation and application left up to the
individual entity
Similar accounting treatment required in broadly similar situations, regardless of possibly
different underlying circumstances (rigid uniformity)
Accounting treatment that takes into account different economic circumstances in broadly
similar transactions (finite uniformity)
The second and third definitions differ from the first because they are concerned with the
degree of uniformity that enters into interpretation of transactions. The first definition simply
prescribes a broad theoretical framework to serve as a basis for interpretation of transactions.
The difference between rigid and finite uniformity is best described by illustration.
SFAS No. 2, which requires immediate expensing of research and development (R&D) costs,
is an example of rigid uniformity. Different expectations apply to the broad category of R&D in
terms of cash flows that are received from these costs, but the treatment is uniform even
though different patterns of receipt of benefits exist. SFAS No. 13 is an example of finite
uniformity. The statement sets down some rather specific criteria for differentiating between
capital and operating leases. Hence, different circumstances are taken into account in
distinguishing accounting for the two types of leases (we are not concerned here with the
question of agreement in terms of the capitalization criteria). Rigid and finite uniformity are
extensively discussed in Chapter 9.
Equity Theories
The enterprise interfaces with owners in the owners ' equity accounts. Several deductive
theories attempt to depict this relationship and are useful in interpreting nonlegal rights and
interests in the owners ' equity accounts as well as in determining certain components of
income. Previously, these normative theories received considerable attention, but today they
play a secondary role to newer, empirical research approaches. The problem with the equity
theories is that the relationship between the firm and its owners, while important, does not
really provide an adequate base from which to define and interpret all enterprise events.
Some writers state that to attain consistency, one equity theory must be selected and adhered
to, but we do not believe this is necessary. However, these theories, though selectively
applied, can still provide useful insights.
Proprietary Theory
The proprietary theory assumes that the owners and the firm are virtually identical. This
theory, which dates back centuries, is quite descriptive of economies made up largely of the
small owner-operated firms that existed prior to the Industrial Revolution. However, Merino ' s
thesis is that the proprietary theory was modified in the late 19th century in response to the
growth of large oligopolistic firms.64 At that time, many reformers desired more governmental
intervention against absentee owners who were reaping large returns. Proprietary theorists,
according to Merino, attempted to bring the absentee owner to center stage when viewing the
business enterprise. These absentee ownership claims were legitimized by measuring profit
available for distribution to owners rather than the notion that earnings ' and capital '
belonged to the corporation itself.65
Under proprietary theory, the assets belong to the firm ' s owners, the liabilities are their
obligations, and ownership equities accrue to the owners. The balance sheet equation is

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(5.1)
Expenses include deductions for labor costs, taxes, and interest but not for preferred and
common dividends. In other words, income represents the owners ' increase in both net
assets (assets minus liabilities) and owners ' equities arising from operations during the
period. The essentials of the proprietary approach largely coincide with the components of
income measurement as it is presently construed in historical cost-based systems, although
owners certainly do not exercise the control over owners ' equity accounts suggested by
proprietary theory. Furthermore, the relationship between the firm and its owners has
changed markedly since the advent of the giant corporation in technologically advanced
societies.
While Merino sees profit available for dividends as a very important idea in the development of
the proprietary theory, several writers see wealth ' represented by the balance sheet ' as being
a more important concept than income under the proprietary theory. Consequently, these
individuals see either general price-level adjustment or current value approaches as integral
to proprietary theory but not entity theory.66 However, Merino points out that those who tried
to revamp proprietary theory at the end of the 19th century also wanted accounting elevated
to the level of a science that was “fact-oriented,” which, in turn, led to a justification of
historical costs.67 We do not believe that either entity or proprietary theory is rich enough in
basic assumptions to arrive at a justification for a historical-cost-based system or departures
from it.
Entity Theory
Dissatisfaction with the orientation of the proprietary theory led to development of the entity
theory. Its chief architect was William A. Paton, long-time professor at the University of
Michigan.68 Under the entity theory, the firm and its owners are separate bodies. The assets
belong to the firm itself; both liability and equity holders are investors in those assets with
different rights and claims against them. Therefore, the balance sheet equation is
(5.2)
Under orthodox entity theory, there is a dual nature to both the owners ' equity accounts and
the question of the primary claim to income.69 Stockholders have rights relative to receiving
declared dividends, voting at the annual corporate meeting, and sharing in net assets after all
other claims have been met, if the firm is dissolving. Nevertheless, owners ' equity accounts
do not represent their interest as owners but simply their claims as equity holders. Similarly,
net income does not belong to the owners, although the amount is credited to the claims of
equity holders after all other claims have been satisfied. Income does not belong to capital
providers until dividends are declared or interest becomes due. In measuring income, both
interest and dividends represent distributions of income to providers of capital. Hence, both
are treated the same and neither is a deduction from income.
If the entity theory is taken to its logical ' and unorthodox ' conclusion, the owners ' equity
accounts belong unequivocally to the firm, despite the presence of stockholder claims.

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Furthermore, income belongs to the firm itself, and, in turn, interest and dividends both
become deductions in calculating the entity ' s net income.70
The same inconsistency relative to valuation systems and proprietary theory previously
discussed is also applicable to the entity theory. Paton and Littleton, in their famed
monograph which is considered to be the classic statement of the historical cost system, take
a strong entity theory position. Littleton, in Structure of Accounting Theory, held to this same
position. Later, Paton, however, moved toward general price-level adjustment, which Devine
saw as being totally consistent with the entity orientation.71 We agree, but would again note
that proprietary theory is also considered to be consistent with general price-level adjustment
because of its presumed wealth orientation.
Anthony provided an interesting variant on this more restricted interpretation of the entity
theory.72 As described, the right-hand side of the balance sheet consists of four main
components: liabilities, shareholder equity, equity interest, and entity equity. Shareholder
equity consists of contributed capital, and equity interest is composed of unpaid dividends on
both common and preferred stock. Interest cost to the firm consists of both interest on debt
and interest cost on the shareholder equity.73 Entity equity is equivalent to retained earnings
but is lower than the latter by the amount of unpaid dividends on both preferred and common
stock. The shareholder-equity interest rate suggested by Anthony is set equal either to the
firm ' s before-tax debt rate or to a specified published rate applicable to all firms set by the
United States Treasury Department in accordance with Cost Accounting Standard 414, which
was published by the now defunct Cost Accounting Standards Board.
Although the entity theory provides a good description of the relationship between the firm
and its shareholders, its dual nature relative to income and owners ' equity in the traditional
form is probably responsible for the fact that its precepts do not hold a strong position in
committee reports and releases of various accounting bodies.74
Residual Equity Theory
The residual equity theory is a variant of both proprietary and entity theory. The theory was
developed by George Staubus, but its roots also lie in the work of William A. Paton.75 The
residual equity holders are that group of equity claimants whose rights are superseded by all
other claimants. This group is the common stockholders, although its members can change if
an event such as a reorganization occurs. Common stockholders are, of course, the ultimate
risk takers within an enterprise. Their interest in the firm serves as a buffer or protector for all
groups with prior claims on the firm, such as preferred stockholders and bond owners.
The underlying assumption of the residual equity theory is that information appropriate for
decision-making purposes (predicting cash flows, for example) must be supplied to the
residual equity holders. The balance sheet equation under this approach is
(5.3)
Although the assets are still owned by the firm, they are held in a trust type of arrangement
and management ' s objective is maximization of the value of the residual equity. Income

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accrues to the residual equity holders after all other claims have been met. Interest and
preferred dividends (but not common dividends) are deductions in arriving at income.
Regarding a FASB discussion memorandum concerned with whether the distinction between
debt and equity should be maintained, Clark asserted that the distinction should be kept. She
based her position on recent finance literature, which found that the amount of leverage
employed by firms (which distinguishes between debt and equity) affects the risk and return
to common stockholders.76 The higher the leverage, the more risk borne by shareholders and
the greater the required return on common shares. In addition, Clark noted that the finance
literature also found that preferred stockholder claims are viewed as debt, that is, however,
subordinate to bonds. Clark, therefore, includes preferred stock as an element of debt in
debt/equity ratio calculations, clearly a residual equity position. She also sees modern finance
theory as more in line with proprietary theory as opposed to entity theory because the latter
does not distinguish sharply between debt and equity.
The development of the residual equity approach is relatively recent. Nevertheless, it has
undoubtedly played a role in the movement toward defining objectives of income
measurement with an emphasis on measures that aid in predicting future cash flows.
Fund Theory
Fund theory, developed by William J. Vatter, backs away from both the entity and proprietary
theories because of the inherent weaknesses and inconsistencies of both.77 A fund is simply
a group of assets and related obligations devoted to a particular purpose, which may or may
not be that of generating income. The balance sheet equation is
(5.4)
The restrictions on the assets arise from both liabilities and invested capital. The invested
capital must be maintained intact unless specific authority for partial or total liquidation is
given. The restriction on assets also includes the specific purposes for their use mandated by
law or contract. Fund theory, therefore, is most applicable to the governmental and not-for-
profit areas where special-asset groups often devoted to specific and separate purposes (e.g.,
endowment funds and encumbrances) prevail.
Commander Theory
Louis Goldberg was uncomfortable with artificial concepts such as “funds” and “entities.”78 As
a result, he proposed the commander theory. Commander i s r e a l l y a s y n o n y m f o r
management, and Goldberg was very much concerned with the fact that management needs
information so that it can carry out its control and planning functions on behalf of owners.
Hence, commander theory might really be viewed as being applicable to managerial
accounting rather than financial accounting, but the manager in his or her fiduciary role must
apply the commander view to the investor.79
Commander theory creates more problems than it solves. The whole issue of agency theory
arises, although Goldberg ' s work precedes the emergence of agency theory by at least 10
years. In addition, the investors ' usage of financial statements becomes somewhat unclear.

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Unfortunately, Goldberg limits the possible scope of shareholder interest to “big picture”
numbers and relationships such as dividends and return on investment as opposed to
possible interest in slightly lower-level operating measures such as income and return on
sales.80
Outlook on the Equity Theories
We have briefly examined five equity theories. As discussed at the beginning of this section,
the equity theories cannot possibly provide a consistent deductive basis for all accounting
transactions and events because they take only a very limited view of the enterprise: the
relationship between the firm and its owners.81 Nevertheless, we believe that they can be of
some use to standard setters. We wonder if the time is not ripe to combine proprietary and
entity theory approaches and show both numbers.82 In Chapter 12, we suggest that stock
option costs that are an expense to shareholders, but not to the firm, should be deducted
from entity theory income to arrive at proprietary theory income. This solution might resolve
the heated debate that has surrounded the stock option issue.
Summary
Despite APB Statement 4 ' s use of the word principles to describe several concepts, the
postulates – principles approach had, in essence, died out by 1970. Several factors underlie
the failure of the postulates – principles approach and the rise of objectives and standards.
We have discussed the failure of ARS 1 and ARS 3 and the difficulty of building on a
postulate base. The demise of the APB was certainly one of the reasons for the end of the
postulates and principles orientation to standard setting. It is true that by the late 1960s,
despite the publication in 1965 of Grady ' s ARS 7, the APB abandoned this approach.
Nevertheless, the APB was identified with postulates and principles, and its decline signaled
the obsolescence of this orientation as a theoretical underpinning for the standard-setting
process.
Other, more fundamental factors were also at work. New research and committee reports
began taking into account such issues as user needs and diversities, which, in turn, led to a
focus on the objectives of financial statements, considerations that were barely mentioned in
the postulates and principles literature. As a result, new outlooks and approaches to income
formulation and measurement eventually evolved.
The new outlook began stressing the need for objectives and standards. Several of the
concepts loosely labeled as principles ' disclosure, materiality, and uniformity, for example '
eventually found their place in an objectives-oriented framework. Other concepts, such as
going concern and stability of the monetary unit, may also eventually diminish in importance.
The equity theories of accounting are normative – deductive theories based on the
relationship between the corporation and its owners. Although these theories can provide
interesting insights into some problems, their scope is not sufficiently global to permit their
extensive use in solving fundamental accounting problems.
Hence, our attention turns next to objectives and standards.83 In Chapter 6, we examine
important conceptual and institutional pronouncements that occurred after the decline of the
postulates and principles approach.

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Appendix 5-A: The Basic Postulates of Accounting (ARS 1)
Postulates Stemming From the Economic and Political Environment
Postulate A-1. Quantification
Quantitative data are helpful in making rational economic decisions, i.e., in making choices
among alternatives so that actions are correctly related to consequences.
Postulate A-2. Exchange
Most of the goods and services that are produced are distributed through exchange, and are
not directly consumed by the producers.
Postulate A-3. Entities (including identification of the entity)
Economic activity is carried on through specific units or entities. Any report on the activity
must identify clearly the particular unit or entity involved.
Postulate A-4. Time period (including specification of the time period)
Economic activity is carried on during specifiable periods of time. Any report on that activity
must identify clearly the period of time involved.
Postulate A-5. Unit of measure (including identification of the monetary unit)
Money is the common denominator in terms of which goods and services, including labor,
natural resources, and capital, are measured. Any report must clearly indicate which money
(e.g., dollars, Euros, pounds) is being used.
Postulates Stemming From the Field of Accounting Itself
Postulate B-1. Financial statements (Related to A-1)
The results of the accounting process are expressed in a set of fundamentally related
financial statements that articulate with each other and rest on the same underlying data.
Postulate B-2. Market prices (Related to A-2)
Accounting data are based on prices generated by past, present, or future exchanges that
have actually taken place or are expected to take place.
Postulate B-3. Entities (Related to A-3)
The results of the accounting process are expressed in terms of specific units or entities.
Postulate B-4. Tentativeness (Related to A-4)
The results of operations for relatively short periods of time are tentative whenever allocations

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between past, present, and future periods are required.
The Imperatives
Postulate C-1. Continuity (including the correlative concept of limited life)
In the absence of evidence to the contrary, the entity should be viewed as remaining in
operation indefinitely. In the presence of evidence that the entity has a limited life, it should
not be viewed as remaining in operation indefinitely.
Postulate C-2. Objectivity
Changes in assets and liabilities, and the related effects (if any) on revenues, expenses,
retained earnings, and the like, should not be given formal recognition in the accounts earlier
than the point of time at which they can be measured in objective terms.
Postulate C-3. Consistency
The procedures used in accounting for a given entity should be appropriate for the
measurement of its position and its activities and should be followed consistently from period
to period.
Postulate C-4. Stable unit
Accounting reports should be based on a stable measuring unit.
Postulate C-5. Disclosure
Accounting reports should disclose information necessary to not mislead.
Source: Appendix 5-A from Moonitz, Maurice (1961). Accounting Research Study #1, The
Basic Postulates of Accounting. American Institute of Certified Public Accountants.
Appendix 5-B: A Tentative Set of Broad Accounting Principles for Business Enterprises
(ARS 3)
The principles summarized here are relevant primarily to formal financial statements made
available to third parties as representations by the management of the business enterprise.
The “basic postulates of accounting” developed in Accounting Research Study No. 1 are
integral parts of this statement of principles.
Broad principles of accounting should not be formulated mainly for the purpose of validating
policies (e.g., financial management, taxation, employee compensation) established in other
fields, no matter how sound or desirable those policies may be, in and of themselves.
Accounting draws its real strength from its neutrality among the demands of competing
special interests. Its proper functions derive from the measurement of the resources of
specific entities and of changes in these resources. Its principles should be aimed at the
achievement of those functions.
The principles developed in this study are as follows:

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1. Profit is attributable to the whole process of business activity. Any rule or procedure,
therefore, which assigns profit to a portion of the whole process should be continuously
re-examined to determine the extent to which it introduces bias into the reporting of the
amount of profit assigned to specific periods of time.
2. Changes in resources should be classified among the amounts attributable to
a. Changes in the dollar (price-level changes) that lead to restatements of capital
but not to revenues or expenses.
b. Changes in replacement costs (above or below the effect of price-level changes)
that lead to elements of gain or of loss.
c. Sale or other transfers, or recognition of net realizable value, all of which lead to
revenue or gain.
d. Other causes, such as accretion or the discovery of previously unknown natural
resources.
3. All assets of the enterprise, whether obtained by investments of owners or of creditors,
or by other means, should be recorded in the accounts and reported in the financial
statements. The existence of an asset is independent of the means by which it was
acquired.
4. The problem of measuring (pricing, valuing) an asset is the problem of measuring the
future services, and involves at least three steps:
a. A determination if future services do in fact exist. For example, a building is
capable of providing space for manufacturing activity.
b. An estimate of the quantity of services. For example, a building is estimated to
be usable for 20 more years, or for half of its estimated total life.
c. The choice of a method or basis or formula for pricing (valuing) the quantity of
services arrived at under (2) above. In general, the choice of a pricing basis is
made from the following three exchange prices:
i. A past exchange price, e.g., acquisition cost or other initial basis. When
this basis is used, profit or loss, if any, on the asset being priced is not
recognized until sale or other transfer out of the business entity.
ii. A current exchange price, e.g., replacement cost. When this basis is used,
profit or loss on the asset being priced is recognized in two stages. The
first stage recognizes part of the gain or loss in the period or periods from
time of acquisition to time of usage or other disposition; the second stage
recognizes the remainder of the gain or loss at the time of the sale or
other transfer out of the entity, measured by the difference between sale
(transfer) price and replacement cost. This method is still a cost method;
an asset priced on this basis is being treated as a cost factor awaiting
disposition.
iii. A future exchange price, e.g., anticipated selling price. When this basis is
used, profit or loss, if any, has already been recognized in the accounts.
Any asset priced on this basis is therefore being treated as though it were
a receivable, in that sale or other transfer out of the business (including
conversion into cash) results in no gain or loss, except for any interest
(discount) arising from the passage of time.
The proper pricing (valuation) of assets and the allocation of profit to

accounting periods are dependent in large part on estimates of the
existence of future benefits, regardless of the bases used to price the
assets. The need for estimates is unavoidable and cannot be eliminated

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by the adoption of any formula as to pricing.
a. All assets in the form of money or claims to money should be

shown at their discounted present value or the equivalent. The
interest rate to be employed in the discounting process is the
market (effective) rate at the date the asset was acquired.
The discounting process is not necessary in the case of short-
term receivables where the force of interest is small. The
carrying-value of receivables should be reduced by allowances
for uncollectable elements; estimated collection costs should be
recorded in the accounts.
If the claims to money are uncertain as to time or amount of
receipt, they should be recorded at their current market value. If
the current market value is so uncertain as to be unreliable,
these assets should be shown at cost.
b. Inventories which are readily salable at known prices with readily

predictable costs of disposal should be recorded at net realizable
value, and the related revenue taken up at the same time. Other
inventory items should be recorded at their current (replacement)
cost, and the related gain or loss separately reported. Accounting
for inventories on either basis results in recording revenues, gains,
or losses before they are validated by sale but they are
nevertheless components of the net profit (loss) of the period in
which they occur.
Acquisition costs may be used whenever they approximate current

(replacement) costs, as is probably the case when the unit prices of
inventory components are reasonably stable and turnover is rapid.
In all cases, the basis of measurement actually employed should
be “subject to verification by another competent investigator.”
c. All items of plant and equipment in service, or held in stand-by

status, should be recorded at cost of acquisition or construction,
with appropriate modification for the effect of the changing dollar
either in the primary statements or in supplementary statements. In
the external reports, plant and equipment should be restated in
terms of current replacement costs whenever some significant event
occurs, such as a reorganization of the business entity or its merger
with another entity or when it becomes a subsidiary of a parent
company. Even in the absence of a significant event, the accounts
could be restated at periodic intervals, perhaps every five years.
The development of satisfactory indexes of construction costs and
of machinery and equipment prices assists materially in making the
calculation of replacement costs feasible, practical, and objective.
d. The investment (cost or other basis) in plant and equipment should
be amortized over the estimated service life. The basis for adopting
a particular method of amortization for a given asset should be its
ability to produce an allocation reasonably consistent with the
anticipated flow of benefits from the asset.

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e. All “intangibles” such as patents, copyrights, research and

development, and goodwill should be recorded at cost, with
appropriate modification for the effect of the changing dollar, either
in the primary statements or in supplementary statements. Limited
term items should be amortized as expenses over their estimated
lives. Unlimited term items should continue to be carried as assets,
without amortization.
If the amount of the investment (cost or other basis) in plant and

equipment or in the “intangibles” has increased or decreased as the
result of appraisal or the use of index-numbers, depreciation or
other amortization should be based on the changed amount.
5. All liabilities of the enterprise should be recorded in the accounts and reported in the
financial statements. Those liabilities that call for settlement in cash should be
measured by the present (discounted) value of the future payments or the equivalent.
The yield (market, effective) rate of interest at date of incurrence of the liability is the
pertinent rate to use in the discounting process and in the amortization of “discount”
and “premium.” “Discount” and “premium” are technical devices for relating the issue
price to the principal amount and should therefore be closely associated with principal
amount in financial statements.
6. Those liabilities which call for settlement in goods or services (other than cash) should
be measured by their agreed selling price. Profit accrues in these cases as the
stipulated services are performed or the goods produced or delivered.
7. In a corporation, stockholders ' equity should be classified into invested capital and
retained earnings (earned surplus). Invested capital should, in turn, be classified
according to source, that is, according to the underlying nature of the transactions
giving rise to invested capital.
Retained earnings should include the cumulative amount of net profits and net
losses, less dividend declarations, and less amounts transferred to invested capital.
In an unincorporated business, the same plan may be followed, but the acceptable
alternative of reporting the total interest of each owner or group of owners at the
balance sheet date is more widely followed.
8. A statement of the results of operations should reveal the components of profit in
sufficient detail to permit comparisons and interpretations to be made. To this end, the
data should be classified at least into revenues, expenses, gains, and losses.
a. In general, the revenue of an enterprise during an accounting period represents
a measurement of the exchange value of the products (goods and services) of
that enterprise during that period. The preceding discussion, under 4c (ii), is also
pertinent here.
b. Broadly speaking, expenses measure the costs of the amount of revenue
recognized. They may be directly associated with revenue-producing
transactions themselves (e.g., so-called “product costs”) or with the accounting
period in which the revenues appear (e.g., so-called “period costs”).
c. Gains include such items as the results of holding inventories through a price
rise, the sale of assets (other than stock-in-trade) at more than book value, and
the settlement of liabilities at less than book value. Losses include items such as
the result of holding inventories through a price decline, the sale of assets (other
than stock-in-trade) at less than book value or their retirement, the settlement of
liabilities at more than book value, and the imposition of liabilities through a
lawsuit.

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Source: Appendix 5-B: A Tentative Set of Broad Accounting Principles for Business
Enterprises (ARS 3) is reprinted by permission of the American Institute of Certified Public
Accountants. Journal of Accountancy Online by American Institute of Certified Public
Accountants, Copyright 1963. Reproduced with permission of American Institute of Certified
Public Accountants in the format other book via Copyright Clearance Center.
Questions
1. Do you think the “broad principles” of ARS 3 are really principles as that term is defined
in science?
2. Assuming all other things equal, it is possible that the lower-of-cost-or-market method
can result in any given year in higher income than would be the case under the same
inventory costing method without the use of lower-of-cost-or-market. If so, then lower-
of-cost-or-market cannot be classified as a conservative method. Do you agree with this
statement? Discuss.
3. Why is it that postulates stemming from the economic and political climates as well as
the customs and viewpoints of the business community do not serve as a good
foundation for deducing a set of accounting principles?
4. Using different studies at different times, it still appears to be the case that financial
executives have a higher threshold for materiality than either certified public
accountants or financial analysts, who, in turn, have a higher materiality threshold than
users. Why do you think this ordering exists?
5. Do you think that the so-called equity theories of accounting are really theories in the
scientific sense? How would you classify them?
6. Why do you think the equity theories are less important today than they were 50 years
ago?
7. Four postulates (going concern, time period, accounting entity, and monetary unit)
were discussed as part of the basic concepts underlying historical costing. Can any of
the principles discussed under the same general category be deduced or logically
derived from these postulates?
8. How does agency theory (Chapters 2 and 4) differ from the equity theories discussed in
this chapter?
9. Does the entity theory or the proprietary theory provide a better description of the
relationship existing between the large modern corporation and its owners?
10. Why has the entity theory fragmented into two separate conceptions?
11. Of the nine so-called principles shown in Exhibit 5.1., which do you think are the most
important in terms of establishing a historical costing system?
12. What is the difference between owners ' equity accounts representing shareholders '
claims as equity holders and shareholders ' interests as owners?
13. Postulates are supposed to be tight enough to prevent conflicting conclusions being
deduced from them. Is this the case with ARS 1?
14. Is it fair to categorize ARS 1 and ARS 3 as failures? Why or why not?
15. How do the imperative postulates (Group C) differ from the other two categories of
postulates?
16. Distinguish among the terms realized, realizable, and realization.
17. How do conventional retained earnings differ from entity equity under the Anthony
conception of the entity theory?
18. What inconsistencies does Merino see in the proprietary theory at the turn of the 20th
century before the advent of entity theory?
19. Why is the earnings-per-share calculation an example of the residual equity of a firm

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being broader than merely its current common shareholders?

20. Why is the residual equity theory more in line with Clark ' s assessment of recent
research in finance than entity and proprietary theory?
21. Why do you think that security prices are impacted more by “bad news” than “good
news”?
22. Why do you think that profitability ratios (e.g., return-on-assets) are more sensitive to
the combined effect of immateriality items than would be the case with solvency ratios
(debt-to-equity and current ratios)?
23. At present, the U.S. federal income tax code allows corporations to deduct interest
expense but not cash dividends paid to stockholders. Does the tax code tie in with any
of the equity theories?
24. Why does it make sense to define materiality from the user ' s perspective?
25. What similarities are there between materiality and disclosure?
26. Discuss how the concept of conservatism may be changing as viewed by Watts.
Cases, Problems, and Writing Assignments
1. Assume the following for the year 2000 for the Staubus Company:
$1,000,
Revenues
000
Operating expenses
$400,0
Cost of goods sold
00
$100,0
Depreciation
00
$200,0
Salaries and wages
00
$80,00
Bond interest (8% Debentures sold at maturity value of $1,000,000)
0
$30,00
Dividends declared on 6% Preferred Stock (par value $500,000)
0
Dividends declared of $5 per share on Common Stock (20,000 shares $100,0
outstanding, a par value of $100 per share) 00
a. Determine the income under each of the following equity theories:
Proprietary theory
Entity theory (orthodox view)
Entity theory (unorthodox view)
Residual equity
b. Would any of your answers change if the preferred stock is convertible at any
time at the ratio of 2 preferred shares for 1 share of common stock?
2. Critique A Statement of Basic Accounting Postulates and Principles by the referenced
study group at the University of Illinois (it should be on reserve or otherwise made
available to you). Your critique should cover, but not be restricted to, the following
points:
a. How do the definitions of postulates, concepts, and principles differ?
b. Are the examples of postulates, principles, and concepts consistent with their
definitions?

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c. Does this set of postulates, principles, and concepts provide a legislative body
with a useful framework for deriving operating rules?
3. List and briefly discuss as many areas as you can in which an accepted method or
technique is conservative, including why it is conservative.
4. A few years ago both Halliburton Corporation, a large construction company, and its
auditor, Arthur Andersen, were chided for allowing Halliburton to book a percentage of
cost overruns that Halliburton attempted to collect from customers after projects were
completed, but before both agreed settlements with customers and, of course,
collection thereof. The practice of trying to collect cost overruns in the construction
industry is not uncommon. Until 1998, cost overrun collections were not booked until
received. Since that time, Halliburton “began guessing how much of a disputed
surcharge would ultimately get paid and crediting itself in advance.”
a. Is there a case that can be made for allowing Halliburton to book these
overruns? What arguments, if any, support Halliburton ' s accounting methods?
b. What situations should prevent Halliburton from booking these overruns prior to
collection?
Critical Thinking and Analysis
1. How permanent do you think the postulates and principles underlying historical costing
will be?
2. If you could relate materiality, disclosure, and conservatism to types of measurements
(nominal, ordinal, interval, and ratio scale), how would you?
3. Zeff (2007) describes the SEC ' s positions regarding historical costing in the 20th
century, eventually questioning whether the United States has ever “had a private-
sector process for establishing ‘generally accepted accounting principles. ' ” To what
extent do you agree/disagree with Zeff ' s point?
financial statement
equity (finance)
materiality
equity theory
equities
assets
Halliburton
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Chapter 5 - Postulates, Principles, and Concepts

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Chapter 5 - Postulates, Principles, and Concepts

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Accounting Theory: Conceptual Issues

in a Political and Economic Environment

Contributors: By: Harry I. Wolk, James L. Dodd & John J. Rozycki

Postulates, Principles, and Concepts

After reading this chapter, you should be able to:

Postulates and Principles

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The Special Committee on Research Program

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Accounting Research Study No. 1 (ARS 1)

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Accounting Research Study No. 3 (ARS 3)

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A Perspective on ARS 1 and ARS 3

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Basic Concepts Underlying Historical Costing

Other important works of this period included the following:

Canning ' s attempt to relate asset valuation to future cash flows

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Postulates are basic assumptions concerning the business environment.

A schema of these various concepts is shown in Exhibit 5.1.

Going Concern or Continuity

Exhibit 5.1 Basic Concepts Underlying Historical Costing

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General Underlying Rules of Operation

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General Underlying Rules of Operation

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Unquestionably, conservatism holds an extremely important place in the ethos of accountants.

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cost is assumed to be more conservative.

Watts also sees conservatism as a dominating element of financial accounting.42 He notes

Moonitz construed disclosure as an imperative postulate (C-5). However, he described it in

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An early and extensive attempt to assess quantitative perceptions of materiality was

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As mentioned earlier, output-oriented principles express qualities that financial statements

Obviously, then, comparability is largely dependent on the amount of uniformity attained in

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Residual Equity Theory

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Outlook on the Equity Theories

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Appendix 5-A: The Basic Postulates of Accounting (ARS 1)

Postulates Stemming From the Economic and Political Environment

Postulate A-1. Quantification

Postulate A-2. Exchange

Postulate A-3. Entities (including identification of the entity)

Postulate A-4. Time period (including specification of the time period)

Postulate A-5. Unit of measure (including identification of the monetary unit)

Postulates Stemming From the Field of Accounting Itself

Postulate B-1. Financial statements (Related to A-1)

Postulate B-2. Market prices (Related to A-2)

Postulate B-3. Entities (Related to A-3)

Postulate B-4. Tentativeness (Related to A-4)

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between past, present, and future periods are required.

Postulate C-1. Continuity (including the correlative concept of limited life)